Debt problem and policy response


[Skip to the end]

The ‘problem’ is lack of income to service the debt, not the debt per se. Take a look at the personal income chart, particularly the interest income component.

Restoring the ability to pay restores the quality of the debt.

With the deficit terrorists in charge it’s going to continue ugly for a considerable period of time for the population at large.

Meanwhile, businesses figure out how to scratch out a living with less top line growth and modestly improving earnings, and banks benefit from the net interest margins at the expense of ‘savers’ pretty much offsetting their ongoing loan losses.
So who’s been the big winner this year to date?

Stocks up 50%, financials up more with record earnings in some cases.

Corporate bonds up as corporate borrowing costs fall.

Consumer interest rates remain high.

Household savings earning near 0.

Unemployment near 10%.

GDP now around flat and forecast to modestly improve.

Real wealth is again flowing upward.

>   
>   (email exchange)
>   
>   Take a look at this next chart, which has gained some currency in
>   the worried circles of financial people. It’s worth a bit of study.
>   It shows you the other dancers on the floor.
>   

>   
>   The first thing to jump out at you is that subprime is only about
>   a $1.5 trillion market – not anywhere near the biggest of the risky
>   loans. There are other layers here.
>   


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Re: Amendment of ERISA


[Skip to the end]

(an email exchange)

Good find!

yes, this had to have contributed to the boom/bust and encouraged/sustained the rampant lender fraud that has resulted in the elevated defaults.

hopefully the pension funds have learned their lessons (the hard way, unfortunately but as always seems to be the case) and will dig deeper than just using the ratings agencies and diversification when they invest.

Warren

>   
>   On Wed, Sep 24, 2008 at 2:50 AM, Eric Tymoigne wrote:
>   
>   
>   All,
>   
>   I have finally found what I have been looking for a while.
>   
>   ERISA was amended on November 2000 to allow Pension Funds and Employer
>   benefit program to buy ABSs with investment grade below A, and to buy senior
>   tranches of CDOs as long as they have an investment grade of at least AA (at
>   least is how I interpret the sentence “the Amendment permits inclusion of
>   assets with LTVs in excess of 100%. However, securities backed by such
>   collateral (a) must be senior (i.e., non-subordinated) securities and (b) must
>   be rated in either of the two highest generic ratings categories by a rating
>   agency.”).
>   
>   All this, it seems to me that this is what has allowed, or at least initiated,
>   what we have seen in the 2000s. CDS, CDOs-squared, under-regulated
>   mortgage companies etc. were all there already but not until this came up did
>   the all thing got out of hand and subprime mortgage started to boom.
>   
>   Any thoughts?
>   
>   Best,
>   Eric
>   


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NYT: Mortgages


[Skip to the end]

(an email exchange)

>   
>   On Mon, Aug 4, 2008 at 7:50 AM, Russell wrote:
>   
>   I am more and more convinced housing is not near a bottom.
>   Granted, I have no idea what the recent Housing Bill will do. But I
>   think housing problems are going to cover the entire swath of
>   America – not only Subprime, but also Alt A and even Prime.
>   
>   

could be, but would be very unusual in an economy with a growing gdp supported by what may now be endless fiscal packages.

the actual housing slump could be mostly old news unless/until gdp softens again as most are forecasting in q4.


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February 19 recap

Might be a revealing day coming up.

I’m watching for markets to begin to link higher oil prices to the potential for higher interest rates, rather than the reverse as has been the case since August.

With oil up to the mid 97 range this am, the question is whether short term interest rates move higher due to possible Fed concerns about inflation, even with weak growth and continuing financial sector issues. Even Yellen recently voiced concerns about energy prices now feeding into core inflation measures which are now above her ‘comfort zone.’ And Friday Mishkin said more than once in a short speech that the Fed had to be prepared to reverse course if inflation expectations elevate.

Yes, credit spreads are a lot wider, but when, for example, I ask the desk if any of the wider AAA’s are ultimately money good, I get a lot of uncertainty. So it seems to me in many cases markets are functioning to price risk at perceived potential default levels? So some of the current spreads may be wider than they ‘should be’ but maybe not all that much?

Yes, the financial sector has been damaged (and damnaged).

Yes, housing is weak without the bid for subprime housing of 18 months ago.

And yes, the consumer has slowed down some.

However, exports are booming like a third world country- growing around 13% per year, also do to financial market shifts, this time away from $US financial assets.

This is offsetting weakening domestic demand and keeping gdp positive, at least so far.

Meanwhile, it looks like a full blow 1970’s inflation in the making if food, fuel, and import/export prices keep doing what they are doing.

And with Saudi production continuing to creep up at current pricing, seems demand is more than strong enough for them to keep hiking prices.

And suddenly Yellen and Mishkin, both doves, substantially elevate their anti inflation rhetoric, as core levels have gone just beyond even their comfort zones.

The full employment recession is spreading

Looks like the US full-employment recession is spreading:

UK jobless rate falls to 5.2 percent in latest quarter

The unemployment rate in the United Kingdom in the last quarter of 2007 fell to 5.2 percent, down from 5.4 percent in the previous quarter, the government said Wednesday.

Average earnings, including bonuses, rose 3.7 percent in the fourth quarter compared with a year earlier, the Office for National Statistics said.

Yes, unemployment is a lagging indicator, but the subprime housing collapse is well over a year old. And the 4.9% rate in the US is, even by Yellen’s standards, ‘very close’ to full-employment.


Summary of subprime bank losses

Spread around enough so no one went out of business, and most lost less then a quarter’s worth of earnings. And a chunk of it probably recoverable.

It’s been a year and the total has to be at the low end of expectations, but could be a lot more to surface in a lot of small pieces around the world.

Seems that only when the Fed sees signs of general progressive improvement vs the current perception of continuing deterioration will they stop cutting.

Subprime Bank Losses Reach $133 Billion, Led by Merrill: Table

by Yalman Onaran

Jan. 22 (Bloomberg) The following table shows the $133 billion in asset writedowns and credit losses since the beginning of 2007, including reserves set aside for bad loans, at more than 20 of the world’s largest banks and securities firms.

The charges stem from the collapse of the U.S. subprime mortgage market and its repercussions on the rest of the housing industry. The figures, from company statements and filings, incorporate some credit losses or writedowns of other mortgage assets caused by subprime crisis.

Analysts estimate additional writedowns and credit losses of $23.5 billion, which would bring the total to $157 billion. All figures are in billions and are net of financial hedges the firms used to mitigate their losses.

*T

Firm Writedown Credit Loss Total
Merrill Lynch $24.5 $24.5
Citigroup 19.6 2.5 22.1
UBS 14.4 14.4*
HSBC 0.9 9.8 10.7
Morgan Stanley 9.4 9.4
Bank of America 7 0.9 7.9
Washington Mutual 0.3 6.2 6.5**
Credit Agricole 4.9 4.9*
Wachovia 2.7 2 4.7
JPMorgan Chase 1.6 1.6 3.2
Canadian Imperial (CIBC) 3.2 3.2**
Barclays 2.7 2.7*
Bear Stearns 2.6 2.6
Royal Bank of Scotland 2.5 2.5*
Deutsche Bank 2.3 2.3
Wells Fargo 0.3 1.4 1.7
Lehman Brothers 1.5 1.5
Mizuho Financial Group 1.5 1.5
National City 0.4 1 1.4
Credit Suisse 1 1
Nomura Holdings 0.9 0.9
Societe Generale 0.5 0.5
Japanese banks
(excluding Mizuho, Nomura)
0.8 0.4 1.2
Canadian banks
(excluding CIBC)
1.4 0.1 1.5
____ _____ _____
TOTALS*** $107 $26 $133

* Includes losses the company expects to report in the fourth quarter of 2007.
** Includes losses the company expects to report in the first quarter of 2008.
***Totals reflect figures before rounding.
*T

–With reporting by Samar Srivastava in New York, Doug Alexander in Toronto. Editors: Steve Dickson, Dan Kraut.


ECB reiterates rate hike warning

ECB reiterates rate hike warning

FRANKFURT(AFP): The European Central Bank (ECB) reiterated Thursday a strong warning about eurozone inflation, calling for price and wage moderation and suggesting it would raise interest rates if necessary.

A monthly ECB bulletin said it was “absolutely essential” that long-term inflation be avoided, underscoring that the bank “remains prepared to act pre-emptively so that second-round effects” do not materialise. Such effects include further consumer price increases and excessive pay increases. The ECB said inflation pressure “has been fully confirmed” after eurozone consumer prices rose by 3.1 percent in December, the biggest increase in six-and-a-half years.

The report was released a day after Yves Mersch, Luxembourg central bank chief and a member of the ECB board, spoke in an interview of “factors that mitigate inflation risks” and suggested the ECB should “be cautious” amid widespread economic uncertainty. That was taken to mean the bank could lower its main lending rate, currently at 4.0 percent, causing the euro to fall below $1.46 on foreign exchange markets.

Like ECB president Jean-Claude Trichet on Wednesday, the bulletin confirmed the bank’s economic outlook: “That of real GDP (gross domestic product) growth broadly in line with trend potential” of around two percent. But it acknowledged that this projection was subject to high uncertainty owing to the US housing crisis and its unknown final effect on the global economy.

Wording of the bulletin matched that of a press conference by Trichet on January 10, when the bank left its key interest rate unchanged. Among other threats to the economy, the ECB pointed Thursday to persistently high prices for oil and other commodities. While acknowledging growth risks, the bank has stressed concern about rising prices and said that keeping inflation expectations under control was its “highest priority,” suggesting it was more inclined to raise interest rates than to lower them.

Many economists have cast doubt on such a possibility however since the US Federal Reserve and Bank of England have begun a cycle of interest rate cuts.

Faced with such scepticism, Trichet raised his tone last week, saying the bank would not tolerate an upward spiral in consumer prices and wages, a message in part to trade unions gearing up for pay talks.

Faced with drops in purchasing power, labour representatives have become particularly militant in Germany, the biggest eurozone economy. The ECB has raised its rates eight times since an increase cycle began in December 2005, with the benchmark lending rate rising from two to four percent.

An additional hike was expected in September but rates remained on hold owing to the US subprime mortgage market crisis.


♥

The subprime mess

On Jan 5, 2008 9:40 PM, Steve Martyak wrote:
> http://www.autodogmatic.com/index.php/sst/2007/02/02/subprime_credit_crunch_could_trigger_col
>
>
> also….
>
> 9/4/2006
> Cover of Business Week: How Toxic Is Your Mortgage? :.
>
> The option ARM is “like the neutron bomb,” says George McCarthy, a housing
> economist at New York’s Ford Foundation. “It’s going to kill all the people
> but leave the houses standing.”
>
> Some people saw it all coming….
>

The subprime setback actually hit about 18 months ago. Investors stopped funding new loans, and would be buyers were were no longer able to buy, thereby reducing demand. Housing fell and has been down for a long time. There are signs it bottomed October/November but maybe not.

I wrote about it then as well, and have been forecasting the slowdown since I noted the fed’s financial obligations ratio was at levels in March 2006 that indicated the credit expansion had to slow as private debt would not be able to increase sufficiently to sustain former levels of GDP growth. And that the reason was the tailwind from the 2003 federal deficits was winding down. as the deficit fell below 2% of GDP, and it was no longer enough to support the credit structure.

Also, while pension funds were still adding to demand with their commodity allocations, that had stopped accelerating as well and
wouldn’t be as strong a factor.

Lastly, I noted exports should pick up some, but I didn’t think enough to sustain growth.

I underestimated export strength, and while GDP hasn’t been stellar as before, it’s been a bit higher than i expected as exports boomed.

That was my first ‘major theme’ – slowing demand.

The second major theme was rising prices – Saudis acting the swing producer and setting price. This was interrupted when Goldman changed their commodity index in aug 06 triggering a massive liquidation as pension funds rebalanced, and oil prices fell from near 80 to about 50, pushed down a second time at year end by Goldman (and AIG as well this time) doing it again. As the liquidation subsided the Saudis were again in control and prices have marched up ever since, and with Putin gaining control of Russian pricing we now have to ‘price setters’ who can act a swing producers and simply set price at any level they want as long as net demand holds up. So far demand has been more than holding up, so it doesn’t seem we are anywhere near the limits of how high they can hike prices.

Saudi production for December should be out tomorrow. It indicates how much demand there is at current prices. If it’s up that means they have lots of room to hike prices further. Only if their production falls are they in danger of losing control on the downside. And I estimate it would have to fall below 7 million bpd for that to happen. It has been running closer to 9 million.

What I have missed is the fed’s response to all this.

I thought the inflation trend would keep them from cutting, as they had previously been strict adherents to the notion that price
stability is a necessary condition for optimal employment and growth.

This is how they fulfilled their ‘dual mandate’ of full employment and price stability, as dictated by ‘law’ and as per their regular reports to congress.

The theory is that if the fed acts to keep inflation low and stable markets will function to optimize employment and growth, and keep long term interest rates low.

What happened back in September is they became preoccupied with ‘market functioning’ which they see as a necessary condition for low inflation to be translated into optimal employment and growth.

What was revealed was the FOMC’s lack of understanding of not only market functioning outside of the fed, but a lack of understanding of their own monetary operations, reserve accounting, and the operation of their member bank interbank markets and pricing mechanisms.

In short, the Fed still isn’t fully aware that ‘it’s about price (interest rates), not quantity (‘money supply, whatever that may be)’.

(Note they are still limiting the size of the TAF operation using an auction methodology rather than simply setting a yield and letting quantity float)

The first clue to this knowledge shortfall was the 2003 change to put the discount rate higher than the fed funds rate, and make the discount rate a ‘penalty rate.’ This made no sense at all, as i wrote back then.

The discount rate is not and can not be a source of ‘market discipline’ and all the change did was create an ‘unstable equilibrium’ condition in the fed funds market. (They can’t keep the system ‘net borrowed’ as before) it all works fine during ‘normal’ periods but when the tree is shaken the NY Fed has it’s hands full keeping the funds rate on target, as we’ve seen for the last 6 months
or so.

While much of this FOMC wasn’t around in 2002-2003, several members were.

Back to September 2007. The FOMC was concerned enough about ‘market functioning’ to act, They saw credit spreads widening, and in particular the fed funds/libor spread was troubling as it indicated their own member banks were pricing each other’s risk at higher levels than the FOMC wanted. If they had a clear, working knowledge of monetary ops and reserve accounting, they would have recognized that either the discount window could be ‘opened’ by cutting the rate to the fed funds rate, removing the ‘stigma’ of using it, and expanding the eligible collateral. (Alternatively, the current TAF is functionally the same thing, and could have been implemented in September as well.)

Instead, they cut the fed funds rate 50 bp, and left the discount rate above it, along with the stigma. and this did little or nothing for the FF/LIBOR spread and for market functioning in general.

This was followed by two more 25 cuts and libor was still trading at 9% over year end until they finally came up with the TAF which immediately brought ff/libor down. It didn’t come all the way down to where the fed wanted it because the limited the size of the TAFs to $20 billion, again hard evidence of a shortfall in their understanding of monetary ops.

Simple textbook analysis shows it’s about price and not quantity. Charles Goodhart has over 65 volumes to read on this, and the first half of Basil Moore’s 1988 ‘Horizontalists and Verticalsists’ is a good review as well.

The ECB’s actions indicate they understand it. Their ‘TAF’ operation set the interest rate and let the banks do all they wanted, and over 500 billion euro cleared that day. And, of course- goes without saying- none of the ‘quantity needles’ moved at all.

In fact, some in the financial press have been noting that with all the ‘pumping in of liquidity’ around the world various monetary
aggregates have generally remained as before.

Rather than go into more detail about monetary ops, and why the CB’s have no effect on quantities, suffice to say for this post that the Fed still doesn’t get it, but maybe they are getting closer.

So back to the point.

Major themes are:

  • Weakness due to low govt budget deficit
  • Inflation due to monopolists/price setters hiking price

And more recently, the Fed cutting interest rates due to ‘market functioning’ in a mistaken notion that ff cuts would address that issue, followed by the TAF which did address the issue. The latest announced tafs are to be 30 billion, up from 20, but still short of the understanding that it’s about price, not quantity.

The last four months have also given the markets the impression that the Fed in actual fact cares not at all about inflation, and will only talk about it, but at the end of the day will act to support growth and employment.

Markets acknowledge that market functioning has been substantially improved, with risk repriced at wider spreads.

However, GDP prospects remain subdued, with a rising number of economists raising the odds of negative real growth.

While this has been the forecast for several quarters, and so far each quarter has seen substantial upward revisions from the initial forecasts, nonetheless the lower forecasts for Q1 have to be taken seriously, as that’s all we have.

I am in the dwindling camp that the Fed does care about inflation, and particularly the risk of inflation expectations elevating which would be considered the ultimate Central Bank blunder. All you hear from FOMC members is ‘yes, we let that happen in the 70’s, and we’re not going to let that happen again’.

And once ‘markets are functioning’ low inflation can again be translated via market forces into optimal employment and growth, thereby meeting the dual mandate.

i can’t even imagine a Fed chairman addressing congress with the reverse – ‘by keeping the economy at full employment market forces will keep inflation and long term interest rates low’.

Congress does not want inflation. Inflation will cost them their jobs. Voters hate inflation. They call it the govt robbing their
savings. Govt confiscation of their wealth. They start looking to the Ron Paul’s who advocate return to the gold standard.

That’s why low inflation is in the Fed’s mandate.

And the Fed also knows they are facing a triple negative supply shock of fuel, food, and import prices/weak $.

While they can’t control fuel prices, what they see there job as is keeping it all a relative value story and not ‘monetizing it into an
inflation story’ which means to them not accommodating it with low real rates that elevate inflation expectations, followed by
accelerating inflation.

There is no other way to see if based on their models. Deep down all their models are relative value models, with no source of the ‘price level.’ ‘Money’ is a numeraire that expresses the relative values. The current price level is there as a consequence of history, and will stay at that level only if ‘inflation expectations are well anchored.’ The ‘expectations operator’ is the only source of the price level in their models.

(See ‘Mandatory Readings‘ for how it all actually works.)

They also know that food/fuel prices are a leading cause of elevated inflation expectations.

In their world, this means that if demand is high enough to drive up CPI it’s simply too high and they need to not accommodate it with low real rates, but instead lean against that wind with higher real rates, or risk letting the inflation cat out of the bag and face a long, expensive, multi year battle to get it back in.

They knew this at the Sept 18 meeting when they cut 50, and twice after that with the following 25 cuts, all as ‘insurance to forestall’ the possible shutdown of ‘market functioning’.

And they knew and saw the price of this insurance – falling dollar, rising food, fuel, and import prices, and CPI soaring past 4% year over year.

To me these cuts in the face of the negative supply shocks define the level of fear, uncertainty, and panic of the FOMC.

It’s perhaps something like the fear felt by a new pilot accidentally flying into a thunderstorm in his first flight in an unfamiliar plane without an instructor or a manual.

The FOCM feared a total collapse of the financial structure. The possibility GDP going to 0 as the economy ‘froze.’ Better to do
something to buy some time, pay whatever inflation price that may follow, than do nothing.

The attitude has been there are two issues- recession due to market failure and inflation.

The response has been to address the ‘crisis’ first, then regroup and address the inflation issue.

And hopefully inflation expectations are well enough anchored to avoid disaster on the inflation front.

So now with the TAF’s ‘working’ (duh…) and market functions restored (even commercial paper is expanding again) the question is what they will do next.

They may decide markets are still too fragile to risk not cutting, as priced in by Feb fed funds futures, and risk a relapse into market dysfunction. Recent history suggests that’s what they would do if the Jan meeting were today.

But it isn’t today, and a lot of data will come out in the next few weeks. Both market functioning data and economic data.

Yes, the economy may weaken, and may go into recession, but with inflation on the rise, that’s the ‘non inflationary speed limit’ and the Fed would see cutting rates to support demand as accomplishing nothing for the real economy, but only increasing inflation and risking elevated inflation expectations. The see real growth as supply side constrained, and their job is keeping demand balanced at a non inflationary level.

But that assumes markets continue to function, and the supply side of credit doesn’t shut down and send GDP to zero in a financial panic.

With a good working knowledge of monetary ops and reserve accounting, and banking in general that fear would vanish, as the FOMC would know what indicators to watch and what buttons to push to safely fly the plane.

Without that knowledge another FF cut is a lot more likely.

more later…

warren


♥

A very British bubble for Mr Brown

A very British bubble for Mr Brown

Leader
Sunday December 16 2007
The Observer

The buzz words in the world of finance these days are ‘moral hazard’. That is economist-speak for what happens when people who have engaged in risky business and fallen foul of market forces are let off the hook. It is the recognition that when you give dodgy lenders and borrowers an inch, they recklessly gamble for another mile.

When the City started to feel the ‘credit crunch’ over the summer, the Bank of England at first took a tough line on moral hazard. But it subsequently changed its mind. It rescued Northern Rock.

It rescued the depositors. Hardly a moral hazard issue. The shareholders still stand to lose if the assets don’t have the hoped for cash flows over time.

Last week it joined a coordinated action with US, Canadian and European central banks to provide easy credit to any institution that can’t borrow elsewhere.

Sort of, the CB’s job is to administer policy interest rates. And, again, there is nothing yet to indicate shareholders are getting baled out.

That was the right course of action. The banking sector may be in a mess of its own making – it over-exposed itself to US sub-prime mortgages – but the danger to the wider economy of a prolonged cash drought is too big to ignore.

What is a ‘cash drought’???

But even if last week’s intervention gets the wheels of global finance moving again,

Whatever that means. GDP seems to be muddling through as before.

the danger will not have receded. That is because high street lenders have no reason to pass central bank largesse onto their customers. Ordinary people will still find it hard to borrow and will still pay more than before to service their debts.

Haven’t seen any evidence of that, apart from would be subprime borrowers who perhaps never should have had access to funds anyway.

Since Britons are some of the most indebted people in the world, that puts us in a particularly vulnerable position. Per capita, Britons borrow more than twice as much as other Europeans. The average family pays 18 per cent of disposable income servicing debt. If the world economy slumps, the bailiffs will knock at British doors first.

More confused rhetoric. Aggregate demand is about spending. The risk to output and employment remains a slump in spending.

It might not come to that. The best case scenario envisages a mild downturn, consumers turning more prudent, demand dipping and inflation falling, which would free the Bank of England to cut interest rates and re-energise the economy for a prompt comeback.

No evidence cutting rates adds to demand in a meaningful way. It takes a strong dose of fiscal for that or for the non resident sector to start spending its hoard of pounds in the UK.

But in the worst case scenario, the credit crunch turns into a consumer recession.

If it results in a cut in aggregate demand, which it might, but somehow this discussion does not get into that connection.

House prices fall dramatically. People feel much poorer and stop spending.

OK, there is a possible channel, but it is a weak argument. Seems to take a cut in income for spending to fall.

Small businesses can’t get credit and fold.

Could happen, but if consumers spend at the remaining businesses that do not fold and employment and income stays constant, GDP stays pretty much the same.

But high fuel and commodity prices keep inflation high. Unemployment rises

When that happens, it is trouble for GDP, but he skirts around the channels that might lead to a loss of income, spending, and employment.

and millions of people default on their debts. Boom turns to bust.

Right, and the policy response can be an immediate fiscal measure that sustains demand and prevents that from happening.

The problem is with ‘high inflation’ and an inherent fear of government deficits; policy makers may not want to go that route.

The government can hope for the best, but it must prepare for the worst.

Fallout shelters?

That means talking to banks, regulators and debt relief charities to work out ways to help people at risk of insolvency.

Actually, bankruptcy is a means of sustaining demand. Past debts are gone and earned income goes toward spending and often spending beyond current income via new debt.

They must look first at reform of Individual Voluntary Arrangements. These are debt restructuring packages that fall short of personal bankruptcy declarations. In theory, they allow people to consolidate and write off some of their debt, paying the rest in installments.

This could hurt demand unless the installment payments get spend by the recipients.

There is no debtors prison over there anymore, last I heard?

But in practice they are sometimes scarcely more generous than credit card balance transfer deals, with large arrangement fees and tricky small print. There is emerging evidence they have been mis-sold to desperate debtors.

In theory, individuals can also negotiate debt relief directly with banks. But that requires the pairing of a financially literate, assertive consumer with a generous-hearted lender – not the most common combination. The government and banks should already be planning their strategy to make impartial brokering of such deals easier.

But the first hurdle on the way to easing a private debt crisis is political. Gordon Brown has constructed a mythology of himself as the alchemist Chancellor who eliminated the cycle of boom-and-bust from Britain’s economy. To stay consistent with that line, he has to pretend that Britain is well insulated from financial turbulence originating in the US.

Banning CNBC would help out a lot!

That simply isn’t true. The excessive level of consumer borrowing in recent years is a very British bubble and the government can deny it no longer. If the bubble bursts, we will face a kind of moral hazard very different from the one calculated by central banks when bailing out the City. It is the hazard of millions of people falling into penury.

Rising incomes can sustain rising debt indefinitely. It is up to the banks to make loans to people who can service them; otherwise, their shareholders lose. That is the market discipline, not short term bank funding issues.


Strong gdp and high credit losses

CNBC just had a session on trying to reconcile high gdp with large credit losses. Seems they are now seeing the consumer clipping along at a +2.8% pace for Q4. No need to rehash my ongoing position that most if not all the losses announced in the last 6 months would have little or no effect on aggregate demand. Credit losses hurt demand when the result is a drop in spending. And yes, that happened big time when the subprime crisis took the bid away from would be subprime buyers who no longer qualified to buy a house. That probably took 1% away from gdp, and the subsequent increase in
exports kept gdp pretty much where it was. But that story has been behind us for over a year.

The Fed is not in a good place. They should now know that the TAF operation should have been done in August to keep libor priced where they wanted it. They should know by now losses per se don’t alter aggregate demand, but only rearrange financial assets. The should know the fall off in subprime buyers was offset by exports.

The problem was the FOMC- as demonstrated by their speeches and actions- did not have an adequate working understanding of monetary operations and reserve accounting back in August, and by limiting the current TAFs to $20 billion it seems they still don’t even understand that it’s about price, and not quantity. Too many members of the FOMC
are mostly likely in a fixed exchange rate paradigm, with its fix exchange rate/gold standard fractional reserve banking system that drove us into the great depression. With fixed exchange rates it’s a ‘loanable funds’ world. Banks are ‘reserve constrained.’ Reserves and consequently ‘money supply’ are issues. Government solvency is an issue.

With today’s floating exchange rate regime none of that is applicable. The causation is ‘loans create deposits AND reserves,’ and bank capital is endogenous. There are no ‘imbalances’ as all current conditions are ‘priced’ in the fx market, including ANY sized trade gap, budget deficit, or rate of inflation.

The recession risk today is from a lack of effective demand. There are lots of ways this can happen- sudden drop in govt spending, sudden tax increase, consumers change ‘savings desires’ and cut back spending, sudden drop in exports, etc.- and in any case the govt can instantly fill in the gap with net spending to sustain demand at any level it desires. Yes, there will be inflation consequences, distribution consequences, but no govt. solvency consequences.

So yes, there is always the possibility of a recession. And domestic demand (without exports) has been moderating as the falling govt budget acts to reduce aggregate demand. But the rearranging of financial assets in this ‘great repricing of risk’ doesn’t necessarily reduce aggregate demand.

Meanwhile, the Saudis, as swing producer, keep raising the price of crude, and so far with no fall off in the demand for their crude at current prices, so they are incented to keep right on hiking. And they may even recognize that by spending their new found revenues on real goods and services (note the new mid east infrastructure projects in progress) they keep the world economy afloat and can keep hiking prices indefinitely.

And food is linked to fuel via biofuels, and as we continue to burn up every larger chunks of our food supply for fuel prices will keep rising.

The $US is probably stable to firm at current levels vs the non commodity currencies, as portfolio shifts have run their course, and these shifts have driven the $ down to levels where there are ‘real buyers’ as evidenced by rapidly growing exports.

Back to the Fed – they have cut 100 bp into the triple negative supply shock of food, crude, and the $/imported prices, due to blind fear of ‘market functioning’ that turned out to need nothing more than an open market operation with expanded acceptable bank collateral (the TAF program). If they had done that immediately (they had more than one outsider and insider recommend it) and fed funds/libor spreads and other ‘financial conditions’ moderated, would they have cut?

There has been no sign of ‘spillover’ into gdp from the great repricing of risk, food and crude have driven their various inflation measures to very uncomfortable levels,and they now believe they have ‘cooked in’ 100 bp of inflationary easing into the economy that works with about a one year lag.

Merry Christmas!


♥